Investment potential in Russia and Eastern Europe

Russia and Eastern Europe have come a long way from food queues and five-year plans. Today, people are more likely to associate the region with oligarchs and football clubs.

But while any cruise down London's Bond Street would confirm that there's a lot of money emerging from the region, foreign investors have been put off by the rumours of shady deals, heavy-handed government interference and poor transparency.

Is the 'Wild East' simply too wild? Or are there investment opportunities in the region?

Let's have a look at the statistics. The MSCI EM Eastern European index is up 17% over one year - the only region to have risen over 12 months. Much of this has been down to the strength of Russia.

The country is still largely influenced by the commodities cycle. Gavin Haynes, investment director at Whitechurch Securities, says: "Due to Russia's wealth of oil and natural gas supplies, investing in this market has been predominantly a way to benefit from rising energy prices.

"The high correlation to energy prices has been demonstrated by the Russian stockmarket's exceptional performance during the rally in energy prices since March 2009. As the price of oil has plummeted since April on renewed fears of a slowdown in the global economy, the RTS (the main Russian index) has also gone into freefall, though it's still ahead over the year."

Sam Vecht, manager of the East European Investment Trust, says that the remainder of Eastern Europe is divided into three main investment regions: Turkey; Kazakhstan and the Ukraine; and central and Eastern Europe.

The latter is more influenced by its convergence with Western Europe, with many of the Eastern European countries now members of the European Union and some still moving towards membership of the euro.

Of course, this is not as attractive a prize as it was five years ago, but many governments in the region believe that there are still trading advantages to be had by closer ties. Turkey dances to its own tune, but has seen strong economic growth. Kazakhstan and the Ukraine are the truly wild frontiers, building their economies on the back of commodities wealth.

Russian roulette

While these latter countries may be the wildest of the Wild East, Russia still has its fair share of cowboys.

Mark Gordon-James, senior investment manager at Aberdeen Asset Management, says government interference is a reality for foreign investors. He points out that around half of the RTS benchmark index is controlled by the government, which has stakes in all the major companies such as Gazprom.

"Even outside of these companies, the government has policies regarding oil and gas and mining, and taxation on these companies can be very, very high," he says.

"In other areas such as pharmaceuticals and utilities, the government also wants to have a high degree of influence."

Politics is also a problem. Tim Cockerill, head of research at Ashcourt-Rowan, says: "Russia seems stuck, moving neither forwards nor backwards on the political front. A lot of time and effort is spent in-fighting and this detracts from the need to construct a coherent development agenda."

This is a problem because the country is relying on the emergence of strong consumer demand and the development of better infrastructure to fuel the next stage of its development.

At the moment, the wealth that has built up from oil has tended to go to the government and a few lucky individuals. This is great for the oligarchs and for Chelsea Football Club, but has meant that Russia as a whole has not kept up economically with many of its emerging market peers.

Thomas Orthen, portfolio manager of Allianz RCM BRIC Stars fund, says although the beginning of a consumer economy is emerging, much is still influenced by the price of oil. However, he points out that there are some initiatives to reduce state interference. For example, government ministers are no longer appearing on the board of directors for various companies.

Moreover, Haynes believes that many of these problems are already in the price of the Russian market: "Investors have often cited the high political and corporate governance risks associated with this market as a reason for avoiding it.

However, with share valuations in Russia being much lower relative to other key emerging markets, it appears a lot of these risks are already in the price."

Gordon-Williams says: "It will become more attractive for international investors if there is more security in property ownership and shareholder rights, but investors have to be aware that it is not run like other European countries. It is not democratic."

Turkish delight

Until relatively recently, Turkey was everyone's emerging market of choice. Although its accession to the EU seems permanently stalled on the back of various concerns, notably its presence in Cyprus, it has seen strong economic growth.

Elena Shafton, manager of the Jupiter Emerging European Opportunities fund, says that Turkey saw impressive first-quarter growth of 11%, with a leap in lending growth of almost 40%.

However, both Turkish loan growth and its GDP have since slowed. This is partly because of its current account deficit (currently running at high level compared to what it has been historically), but also due to the general malaise in Europe. Yet, Shafton still believes that Turkey has significant potential. She points out that mortgages represent just 5% of GDP and there is a growing population that aspires to consume.

Central Europe had a bad credit crunch as a number of countries found themselves overloaded with foreign-currency denominated debt. This is still a problem, but Vecht says that countries such as Poland, Hungary and the Czech Republic are very competitive economically.

More importantly, he says, companies in this region have the highest growth in earnings per share globally: "This is down to their cheap but highly-skilled workforce, geographic proximity to Europe and low corporate taxation."

He also believes the wild frontiers of Kazakhstan and the Ukraine offer opportunities. Both are emerging from a severe crisis and there is good recovery potential.

Investors willing to risk the Wild East can approach the region through one of the dedicated funds, or opt for a broader emerging markets fund and rely on the manager to make their allocation for them.

Remember, even the adventurers in the Wild West came up with Silicon Valley in the end.